~ Investment Strategy

Morning Note: Greece, Japan, China

Jean-Claude Juncker has criticised other EU leaders for “threatening” Greece with expulsion from the Eurozone, calling the idea that Greece might be forced to leave the Eurozone “nonsense” and “propaganda”. This coheres with my view that what has happened in the past week is that some European policymakers have talked up the possibility of Greek euro exit to put pressure on the Greeks to form a government. On the other hand, it is undeniable that the result of the Greek election made exit from the euro more likely than it was before, and so it is not wholly unreasonable that markets have priced in a higher probability of that tail event.

What has to happen for Greece to leave the Eurozone, given that all the parties are (as far as I know) committed to staying in? The answer is, there is nothing that can make this happen. The political situation in Greece has to change to the extent that the population comes to favour an exit. What has to happen to force that change in the short term? It is possible that Greece could fail to meet the terms of its bailout — either because there is no government or because an anti-bailout government is formed — and thus that the next tranche of aid might not be disbursed. Greece could then default on bond coupon or on a maturing bond (September being the next opportunity for this, I believe). That would entail defaulting on bonds that Greek banks have used as collateral at the ECB. The ECB might then cease to accept Greek bonds as collateral, causing a collapse of the Greek banking system. In the resulting chaos, a government might come to power by pointing out that, if Greece had its own currency, it would be able to support its banks, and that government could then take Greece out of the euro.

As I said in correspondence yesterday, this chain of events requires that:

1. The Greek political situation makes implementation of the bailout terms impossible.
2. The EU will not move on the terms of the bailout and will be prepared to allow Greece to default if the terms are not met.
3. The ECB would cease to offer liquidity support to the Greek banks with the defaulted paper as collateral.

3. is likely; 1. and 2. I am not so sure about. On 1., once a government is formed in Greece, it should be clear to the new prime minister that refusal of the bailout meant economic ruin. While they are out of power, parties may benefit from taking unreasonable positions, if those positions appeal to the electorate; once they are in power, their actions are constrained by reality and they will be punished if they bring about disaster. It is possible, of course, that no government will be formed after the new election, in which case this argument does not apply, and it is also possible that one of the leading parties might be mad — in the sense of “unable rationally to adapt means to ends” — and might refuse to comply with the terms of the bailout on principle (I like to assume that politicians are rational, and that assumption has served me well through the euro crisis so far). In either case, Greece could fail to meet the terms of its bailout.

On 2., Juncker said yesterday, after the ECOFIN meeting: “We wouldn’t close ourselves off to a debate over extending the deadlines” for Greece, provided that the country had a functioning government. But would European politicians really pull the plug on Greece, after everything that has been done to support the country, on account of a temporary inability to form a government? This does not seem at all reasonable. More likely, European politicians would show enough flexibility on extending the deadlines for Greece that a new government could be formed.

Thus, if Greece can form a government, that government ought to go along with the bailout, as long as it is not mad; if Greece cannot form a government, European politicians should give enough ground to allow one to be formed. It is possible that the Greek government might be mad, or that European politicians might give up on Greece, but neither is a reasonable base case.

Japan

Are Japanese equities cheap? The TOPIX is relatively cheap, but the TSE Second Sector index looks very cheap once companies’ high cash holdings are stripped out. With Japanese breakeven inflation having risen sharply over the past few months and now turned positive as a result of the cracks that have appeared in the BoJ’s dam, real interest rates have gone negative and the stimulative effect on the economy should be significant. I think that the dam will continue to weaken — i.e. that the BoJ will try large and perhaps new forms of monetary stimulus in order to end deflation — because politicians have started to demand action from the BoJ and it is they who have created the cracks. So Japanese equities are relatively cheap and the long-run prospects for the economy are improving. That looks like a long-term buying opportunity.

China

China’s latest raft of weak data is causing the market some concern, and I thought it was time for a look at my pack of Chinese indicators. Leading indicators are mixed, with the OECD showing improvement at the margin and Goldman Sachs deterioration. PMI new orders minus inventories has been strong of late. Copper imports are up around 80% YOY, while oil imports are up only 3.3%. New loans disappointed expectations last month and were down on last year’s strong April number, but, in spite of negative media comment, were still on the strong side. Electricity production is at a quite weak 1.5% YOY, having recently fallen from a high of around 20% YOY in February. In summary, China’s data are volatile but there are definite signs of weakness. I think that China is having a policy-induced slowdown and that the economy will rebound when the authorities loosen, but I am aware that China’s investment-driven growth model can probably not be sustained indefinitely and that a reckoning is possible at some point. There is no reason that such a reckoning cannot be kicked off by a tightening of policy.

Data

Australia’s monetary policy minutes showed that the recent cut in rates was based on: below-trend growth and widespread weakness outside the mining sector; inflation that is expected to remain under control; rising bank lending rates (on account of high deposit rates and rising wholesale funding costs); and the negative international situation.